Economics, Politics, Social Commentary and occasionally Superstring Theory.

Tuesday, November 30, 2004

Will A VAT Spur Economic Armageddon?

The Bush Administration is rumored to be considering a value added tax (VAT) to replace the current income tax. A VAT is essentially a national sales tax, assessed at every point there's a cash transaction. Apart and away from the regressive nature of such a tax, I have the following concerns.

1. While I agree that something needs to be done to spur more national saving in the U.S., I am not convinced a VAT is the way to go. I think the national savings needs to occur more at the governmental, rather than the individual, level. Individuals can save all they want, but if the government keeps borrowing it for unsustainable deficits, then it really doesn't do any good. Does it really matter if the governmental debt belongs to Americans or Chinese?

2. A VAT will functionally increase prices for everything. This will drive down demand for non-essential goods. A chunck of non-essential goods are manufactured in China. A shortage of demand for Chinese produced goods will have a significant impact on their economy. If Chinese employment slackens because of downward demand for their goods manufactured for export to the U.S., then China's savings rate will go down. This will mean they will lose their ability to absorb our debt at current levels. That means higher interest rates in the U.S. to try to attract others to absorb the debt. So, we have higher prices across the board and higher interest rates.

3. A VAT is going to put upward pressure on wages because prices for almost every product will go up. An increase in wages without a corresponding increase in productivity means that companies will have to increase their prices irrespective of the VAT to afford to keep the workers they don't end up laying off. This looks like it could set off a dangerous cycle of inflation. Think of a VAT like the Oil Shocks of the 1970's. Both have the effect of suddenly reducing disposable income by increasing prices for essential products.

4. The U.S. seems to have adopted an implicit policy of demand and consumption-led growth. A VAT dampens demand.

5. A recession is defined as when demand falls below supply. The U.S. has just clawed itself out of a relatively shallow recession partly by (extemely inefficiently) cutting taxes and printing money. The recovery to this point has been fragile. Anything that serves to dampen demand at this point would probably plunge the economy back into a recession.

How far off base am I here?

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